Household Heterogeneity and Real Exchange Rates*


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     This article was prepared for the Economic Journal Lecture at the 2006 Royal Economic Society meetings. Kocherlakota thanks Winnie Choi for many stimulating conversations about real exchange rates. Kocherlakota acknowledges the support of NSF 0305833 and 0606695. We thank an associate editor of the Journal, George Alessandria and Ivan Werning for helpful comments, Jaromir Nosal and Sonam Sherpa for research assistance, Orazio Attanasio and Andrew Leicester for help with the FES data, and Joan Gieseke and Hakki Yazici for editorial assistance. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.


We assume that individuals can fully insure themselves against cross-country shocks but not against individual-specific shocks. We consider two particular models of limited risk-sharing: domestically incomplete markets (DI) and private information–Pareto optimal (PIPO) risk-sharing. For each model, we derive a restriction relating the cross-sectional distributions of consumption and real exchange rates. We evaluate these restrictions using household-level consumption data from the US and the UK. We show that the PIPO restriction fits the data well when households have a coefficient of relative risk aversion of around 5. The restrictions implied by the complete risk-sharing model and the DI model fare poorly.